Working Capital Management Notes

Chapter 9: Working Capital Management - Part 1

Lesson Objectives

• Enumerate and describe current asset investment and financing policies.

• Discuss the objectives of cash/marketable securities management, inventory management, and receivables management.

• Discuss methods to manage cash/marketable securities, inventories, and receivables.

• Perform cash/marketable securities management techniques.

• Perform receivables management techniques.

• Perform inventory management techniques.

What Is Working Capital Management?

• Working capital management refers to the management of a company’s current assets and current liabilities.

• It involves determining the optimal levels of cash/marketable securities, accounts receivable, and inventory.

• It also includes financing working capital at the lowest possible cost.

Objective of Working Capital Management

• The main objective is to maintain working capital at appropriate levels.

• This ensures the company's ability to operate as a going concern.

• The type of business determines the necessary level of working capital.

• It also influences current asset investment and financing policies.

Importance of Working Capital Management

• Working capital management is important because it creates value.

• Too little working capital can disrupt business operations.

• Too much working capital may entail substantial opportunity costs.

• It provides companies with a competitive advantage.

• It can result in growth in profitability and market value.

• It enables companies to take advantage of investment opportunities and enhance their reputation.

Advantages of Maintaining Working Capital

• Enables business operations to continue seamlessly.

• Provides liquidity and increases debt capacity.

• Increases production and fixed asset efficiency.

• Allows exploitation of favorable opportunities.

• Allows distribution of dividends.

Disadvantages of Excessive or Redundant Working Capital

• Low rate of return/lower profitability.

• Decline in capital and efficiency.

Current Asset Investment Policies

• Relaxed (liberal) investment policy.

• Restricted (tight or “lean and mean”) investment policy.

• Moderate (balanced) investment policy.

Which Current Asset Investment Policy Should Be Adopted?

• The optimal strategy is to choose the policy that maximizes the company’s long-run profitability and intrinsic value.

• It depends on the nature of the industry and the risk appetite of company’s management.

Current Asset Financing Policies

• Conservative financing policy.

• Aggressive financing policy.

• Maturity matching financing policy.

Which Current Asset Financing Policy Should Be Adopted?

• There is no single correct answer.

• The industry may determine the appropriate policy.

• The risk appetite of company’s management is also pivotal.

Objectives of Current Asset Management

• To optimize the time between initial input of materials and the time customers pay.

• To shorten the cash conversion cycle without negatively impacting operations.

Current Assets That Are Frequently Managed

• Cash and marketable securities.

• Receivables.

• Inventories.

Cash and Marketable Securities – Definition

• Cash is the most liquid asset and is easily convertible to other assets or used to pay off debts.

• Marketable securities are low-risk, short-term investments classified as cash equivalents due to their high liquidity.

• They enable investors to invest excess cash safely while generating a return.

Cash and Marketable Securities – Motives for Holding Cash

• Transaction motive.

• Precautionary motive.

• Speculative motive.

• Contractual/Compensating balance motive.

Cash and Marketable Securities – Reasons for Holding Marketable Securities

1. Frees up cash for other purposes.

2. Produce at least a modest return, whereas cash produces none.

3. Can be used in place of transaction, precautionary, and speculative balances.

4. Can be used to meet known financial obligations.

Cash and Marketable Securities – Cash Conversion Cycle

• The cash conversion cycle is the time it takes to convert raw materials into finished goods, sell the goods, and collect receivables, less the time to pay for materials and labor.

• Formula: $CCC = ICP + RCP – PDP$

  • CCC = Cash Conversion Cycle

  • ICP = Inventory Conversion Period

  • RCP = Receivables Collection Period

  • PDP = Payables Deferral Period

Cash and Marketable Securities – Operating Cycle

• The operating cycle refers to the time it takes to convert raw materials into finished goods and to sell the goods, plus the time required to convert receivables into cash.

• Formula: $OC = ICP + RCP$

  • OC = Operating Cycle

  • ICP = Inventory Conversion Period

  • RCP = Receivables Collection Period

Cash and Marketable Securities – Cash Management Techniques

1. Improvement of cash flow forecasts.

2. Synchronization of cash flows.

3. Maintaining zero-balance accounts.

4. Playing the float (disbursement float, collections float, and net float).

• Acceleration of receipts (electronic fund transfer, automatic bank credits, lockbox plan/system, concentration banking).

• Deceleration of payments.

• Centralization of payables.

• Use of an overdraft system.

Cash and Marketable Securities – Cash Management Models

1. Cash budget: A table displaying cash receipts, cash disbursements, and balances over a given time period.

2. Cash break-even chart: A chart illustrating the level of output or sales at which sales revenue equals total cash outflow.

• Baumol model: An EOQ-type model to find the optimal cash balance (Z) under certainty.

  • $Z = \sqrt{\frac{2D \times TC}{i}}$

    • D = Demand

    • TC = Transaction Cost

    • i = Interest rate

• Miller-Orr model/Return point model: Determines the optimal cash balance (Z) under uncertainty.

  • $Z = \sqrt[3]{\frac{3 \times TC \times V}{4 \times r}} + L$

    • TC = Transaction Cost

    • V = Variance of Cash Flows

    • r = Interest Rate

    • L = Lower Limit

Receivables – Definition

• Receivables are amounts owed by customers for goods or services sold but not yet paid for.

• They represent future cash inflows that finance continuing operations and investment opportunities.

• However, they carry the risk of being uncollectible.

Receivables – Objectives of Managing Receivables

1. To strike a balance between profitability and risk.

2. To optimize sales.

3. To minimize the cost of credit.

4. To optimize investment in receivables.

Receivables – Factors Determining Credit Policy

• Credit standards (character, capacity, capital, circumstances).

• Credit terms.

• Collection program/policy.

Receivables – Aging Schedule

• An aging schedule is a report classifying accounts receivable based on how long they have been outstanding.

• It assists in monitoring cash flows and identifying overdue payments.

Inventories – Definition

• Inventories are goods and materials held for sale, manufacture, or use in operations.

• They can be classified as raw materials, work-in-process, or finished goods.

• They are categorized as current assets because they represent an investment in goods to be sold later.

Inventories – Objectives of Inventory Management

1. To ensure the inventory required to sustain operations is available.

2. To keep inventory costs as low as possible, including ordering, carrying, receiving, and stockout costs.

Inventories – Reasons for Keeping Inventory on Hand

1. To fulfill anticipated demands.

2. To protect against shortages.

3. To take advantage of discounts.

4. To minimize inventory costs.

5. To accommodate fluctuating consumption or demand.

6. To facilitate and simplify the production process.

7. To avoid future rising inflation.

8. Process requirements.

Inventories – Inventory Management Techniques

• Inventory planning techniques (EOQ, reorder point, just-in-time systems).

• Inventory control techniques (fixed order quantity system, fixed reorder cycle system, optional replacement system, ABC classification system).

• Modern inventory management techniques (MRP 1, MRP 2, ERP).

Inventories – Inventory Methods/Systems

• Optional replenishment or Min/Max System (s-S Model).

• Red-line method.

• One-bin method.

• Two-bin method.

• Computerized systems.

• Just-in-time (Demand-pull) systems.

• Flexible manufacturing systems.

Inventories – Economic Order Quantity (EOQ)

• The Economic Order Quantity (EOQ) is an inventory management model that refers to the quantity of inventory to order that can minimize the sum of ordering and carrying costs.

• Ordering costs decrease as order size increases.

• Carrying costs increase as order size increases.

• $EOQ = \sqrt{\frac{2(Annual\ usage\ or\ demand\ in\ units)(Ordering\ cost)}{Annual\ carrying\ cost\ per\ unit}}$

Chapter 10: Working Capital Management - Part 2

Lesson Objectives

1. Discuss the factors management use to choose the sources of short-term funds.

2. Enumerate and discuss the different short-term funding sources.

3. Estimate the cost of the different short-term funding sources.

What Is the Main Objective of Current Asset Financing?

• To find the most cost-effective way to fund current asset needs.

Factors in Selecting Short-Term Funding Source

• Effective cost of the funding source.

• Willingness of the funding source to assume risk.

• Flexibility of the funding source.

• Presence of covenants/restrictions.

• Effect of the funding source on credit rating.

• Economic conditions.

Sources of Short-Term Financing

• Spontaneous liabilities (accruals and accounts payable or trade credit).

• Short-term bank loans.

• Commercial papers.

• Lines of credit.

• Revolving credit agreements.

• Factoring of receivables.

Spontaneous Liabilities – Accruals

• Accruals are continuously recurring short-term liabilities that increase spontaneously as the company grows, such as accrued wages and taxes.

• They are similar to interest-free short-term loans.

• Companies cannot control accruals, as payment depends on external factors.

Spontaneous Liabilities – Accounts Payable/Trade Credit

• Accounts payable, also known as trade credit, refers to debt incurred because of credit sales.

• It arises in the normal course of business and increases automatically as the company expands.

• Accounts payable or trade credit has no interest cost as long as it is paid on time.

• It is a significant source of short-term credit particularly for small businesses that cannot obtain short-term financing from other sources.

• Some companies engage in the practice of “stretching accounts payable,” which refers to the act of purposefully paying late.

• This is practiced so that companies can keep cash for longer periods of time, which can then be used for business operations or to earn returns.

• Companies may also stretch their accounts payable to overcome short-term cash problems.

• Total trade credit consists of free trade credit and costly trade credit.

• Free trade credit refers to the credit obtained during the discount period

• costly trade credit refers to the amount of credit taken in excess of the free trade credit.

• Two ways to compute for cost of trade credit are as follows:

• Nominal cost of trade credit

  • \frac{discount\ rate}{ (1 − discount\ rate)} \times \frac{#\ of\ days\ in\ a\ year}{(payment\ date − discount\ date)}

• Effective cost of trade credit

  • \left(1 + \frac{discount\ rate}{ 1 − discount\ rate} \right) ^ {\frac{#\ of\ days\ in\ a\ year}{(payment\ date−discount\ date)}} − 1

Short-Term Bank Loans

• Short-term bank loans are non-spontaneous financing extended by banks to companies that request for them.

• Short-term bank loans typically mature in one year or less, and the terms and conditions of loans are set forth in a promissory note.

• A promissory note is a promise to pay at a specified time or on demand. It would typically include the principal amount owed, maturity date, interest rate, repayment terms, and the signature of the maker of the promissory note.

• Formulae related to short-term bank loans are as follows:

  • Effective interest rate:

    • $\frac{Interest\ paid}{Principal\ available} \times \frac{No.\ of\ days\ in\ a\ year}{No.\ of\ the\ days\ the\ funds\ are\ borrowed}$

  • Total borrowings:

    • $\frac{Amount\ needed}{1-Discount\%-Compensating\ Balance}$

      • If the note is discounted

      • If the bank requires a compensating balance

Commercial Papers

• Commercial papers are unsecured short-term financial instruments issued by large, creditworthy enterprises to finance accounts receivable, inventories, and short- term liabilities.

• The formula to calculate for the effective cost of commercial papers is as follows:

  • $Effective\ cost = \frac{Interest\ cost\ per\ period + Issue\ cost}{Usable\ loan\ amount} \times \frac{No.\ of\ days\ in\ a\ year}{No.\ of\ days\ the\ funds\ are\ borrowed}$

Line of Credit

• A line of credit is an informal agreement between a company and a bank in which a bank agrees to lend the company up to a certain maximum amount of funds over a specified period of time.

• The formulas related to the cost of a line of credit follow:

  • Annual interest

    • $Amount\ borrowed \times Stated\ interest\ rate$

  • Effective annual interest

    • $\frac{Annual\ interest}{Amount\ borrowed}$

Revolving Credit Agreement

• A revolving credit agreement is a formal commitment by a bank or financial institution to extend a line of credit.

• Often, a commitment fee is paid to the bank as part of the arrangement, and revolving credit agreements are frequently used for medium-term financing.

Factoring of Receivables

• Factoring is a source of short-term financing for companies that sell on credit.

• In factoring, a factoring firm (or the factor) purchases a company’s accounts receivable and assumes the risk of collection.

• For bearing the risk, the factoring firm is typically compensated 1% to 3% of accepted invoices.

• The factoring firm also receives interest on the monies advanced to the company that sold its accounts receivable.

• Formulae relating to factoring of receivables:

• Computing for cash received from factoring:

  • Gross proceeds

    • $Amount\ of\ receivables − Reserve − Factor\ fee$

  • Interest expense

    • $Gross\ proceeds \times Interest\ expense \times \frac{No.\ of\ days\ the\ receivables\ will\ be\ due}{No.\ of\ days\ in\ a\ year}$

  • Cash received

    • $Gross\ proceeds − Interest\ expense$

• Computing for effective rate/annual cost of financing

  • Usable funds

    • $Receivables \times Advance\$

  • Annual net cost

    • $Annual\ interest\ expense + Annual\ factor\ fee − Annual\ savings$

  • Effective rate

    • $\frac{Annual\ net\ cost}{Usable\ funds}$